Annual Reports

The Tax Cut Illusion

About This Issue

During 1979 the Federal Reserve System tried to slow the
growth of money, and in 1980 it has renewed its commitment
to this task. Slowing the growth of money is a necessary
step for fighting inflation, but as our 1978 Annual Report
explained, the Fed cannot do the job of fighting inflation
by itself. Monetary policy must be supported by appropriate
fiscal policy.

The lead article in this year's Annual Report discusses
one aspect of fiscal policy that has often appeared in the
news in recent months: the possibility of cutting taxes.
Although a real tax cut would be appealing, this is not
an option that the proponents of cutting taxes usually present.
In fact, most of the tax cuts that are usually offered would
result in higher budget deficits and higher inflation. This
amounts to replacing direct taxes with an inflation tax.
If fighting inflation is vital and urgent, as we strongly
believe, then such tax cuts would be a step backwards.

Of course, if federal government expenditures were reduced along
with taxes, budget deficits and inflation would not necessarily
be pushed higher. In this case, we would have a real cut in taxes—which
could well be good for the economy. Unfortunately, a substantial
cut in government expenditures seems very elusive.

In the second part of this report, the Minneapolis Federal Reserve
Bank's success in lowering unit costs and raising productivity is
documented. Although it may not greatly affect inflation, we are
extremely pleased to report this performance. It is noteworthy that
the Bank was able to cut its unit costs significantly in spite of
high inflation.

A tax cut is often touted as the magical solution
to our economic problems, but a tax cut is not always what it
seems. Most proposals for cutting taxes would not reduce government
expenditures one bit. They are like the magician's trick of sawing
in half the lady in the box. There is a great deal of hoopla while
something appears to be cut, but when it is all over, nothing
much has changed.

In fact, most of the commonly heard proposals for cutting taxes
would not lower the real tax burden—they would probably
increase it. A reduction in taxes without a corresponding reduction
in government expenditures would merely increase our reliance
on deficit spending. This would cause further inflation and make
our economic performance deteriorate. Because of these hidden
costs, a tax cut could easily be concealing an increase in the
real tax burden.

The real tax burden is the amount of resources—goods and
services—that the government removes from the private sector.
Government expenditures account for the major part of the real
tax burden, when the government spends for investment, transfer
programs, consumption, or anything else, it buys labor, expertise,
raw materials, land, buildings, and so forth. Since all these
resources are in limited supply, the private sector must give
them up when the government buys them. The real tax burden is
not what the Internal Revenue Service collects; it is what the
private sector gives up to government.

A smaller, but still significant, part of the real tax burden
consists of the resources that are consumed incidentally because
of the government's taxation policy. These resources are removed
from the private sector but never go to any government purpose.
They are simply lost—not because of ineptness or corruption,
but because every tax causes some resources to be wasted. These
lost resources, sometimes called deadweight loss, include collection
costs: the legislative time devoted to tax laws, the expenses
of tax courts, and the costs of running the IRS. They also include
the productive time or material that is wasted as individuals,
legally and illegally, try to minimize their taxes. Together,
these lost resources and government expenditures compose the real
tax burden.

Most of the proposals for cutting taxes would not reduce the
real tax burden, despite the claims of the newly popular supply-side
theories. They would reduce neither expenditures nor the amount
of wasted resources. They would merely reduce tax revenues—but
reducing tax revenues does not mean that government hires fewer
people, buys fewer buildings, or owns and controls fewer resources
of any other kind. In fact, it could easily mean that government
owns and controls the same resources and runs larger budget deficits.

Deficits and Inflation

Because most proposals for tax cuts are not coupled with any
reduction in government expenditures or deadweight loss, they
would have to increase the federal budget deficit. In effect,
they would replace explicit taxes like the income tax with greater
deficits.

A shift from explicit taxes to deficits does not lower the
real tax burden, whatever else it may do. Increasing federal
debt is a way to conceal taxes, not a way to reduce them. If
the accumulated debt is going to be paid off in the future,
a shift to deficits could indeed postpone taxes for a while.
But the taxes must eventually be paid back with interest.

If, on the contrary, the accumulated debt is not going to
be paid off in the future, then a shift to deficits merely makes
taxes less visible. Currently, it seems safe to assume that
the United States government will not pay off its debt. Since
the 1960s it has not done so, and it appears to have no intention
of doing so. Congress and the administration have sought to
balance the budget only when there is full employment, only
at the peaks of the business cycle. They are clearly saying
that the budget on average will be in deficit. The longer they
follow this policy, the greater the total federal debt will
be.

When the federal government runs a deficit, it simply prints
and sells more bonds. Federal bonds are nothing more than an alternative
form of currency—they are promises to deliver currency in
the future. Like currency, these bonds are pieces of paper backed
by nothing tangible; they are fiat paper. Like currency, they
are a debt that the government never promises to retire. They
are, in all essentials, a part of our ever-expanding money supply.
When the government has no intention of retiring its debt, there
is little difference between currency and bonds; both are money.

In this circumstance, any increase in the deficit is an inflation
tax. As is well understood, government can cause inflation by
printing more money. When more paper is pursuing the same amount
of goods, it takes more paper to buy each good. The value of
the paper declines; the price of goods goes up. Obviously, this
is inflation.

What is not often acknowledged, though, is that this is also
a tax. When the government prints more paper, the government benefits
and the private sector pays. Government can print paper for virtually
nothing and use it to pay consultants' salaries, to construct
buildings, or to acquire other real resources from the private
sector. The private sector then has more paper and fewer goods.
By printing paper, government is able to obtain a larger share
of the available goods, just as if it were taxing its citizens
more. An increase in federal paper—currency or bonds—is
thus really an inflation tax.

The data support the contention that deficits are a means of
levying an inflation tax. In recent years, higher inflation has
accompanied higher deficits. The accumulated federal budget deficit
(the stock of interest-bearing and noninterest-bearing federal
government debt) has expanded much faster in the 1970s than in
the 1960s. In the 1960s, when the deficit grew slowly, the rate
of inflation was very moderate, as Figure 1 shows. In the more
debt-burdened 1970s, in contrast, inflation averaged about 7 percent
per year.

Some Excuses for Deficits

The total federal debt has been increasing; this is the indisputable
consequence of our repeated annual deficits. Some economists,
however, claim that the increase in federal deficits cannot
explain the increase in inflation. They have two main lines
of argument to explain why deficits in the 1970s have not been
large enough to cause inflation to accelerate. Both of their
arguments are off the mark.

They claim, first, that federal deficits are partly offset
by state and local government surpluses. On the surface this
claim may look plausible, because surpluses and deficits are
simply opposite sides of the same thing. A deficit adds to the
amount of bonds a particular government has issued; a surplus
lowers the amount. But federal deficits cannot simply be added
to state and local surpluses. They are not equivalent, and adding
them is like adding apples and oranges.

Deficits from state and local governments are fundamentally different
from those from the federal government. Unlike the federal government,
state and local governments back their bonds with the promise
to tax people. They must repay their debts or go into bankruptcy.
Because their bonds are backed, they have no effect on the amount
of unbacked debt—fiat paper—in circulation. This means
that they have nothing to do with inflation, for only fiat paper
causes inflation.

The surpluses of state and local governments are also quite
unlike those of the federal government. State and local surpluses
simply reduce the amount of backed bonds. They do not reduce
federal debt. They do not reduce the amount of fiat paper in
circulation. They do not reduce the money supply. And they do
not reduce citizens' tax obligations to the federal government.
Adding today's federal deficit to state and local surpluses,
like adding apples to oranges, does not make sense; it makes
fruit cocktail.

The second argument that some economists use to explain why
federal deficits have not been growing fast enough to cause
an increase in inflation is that federal deficits have not grown
in relation to the size of the economy. More specifically, they
claim that when the accumulated federal debt is computed as
a percentage of the gross national product, it has actually
declined in the 1970s. Therefore, they argue, deficits can't
explain the higher inflation rates of the 1970s.

Their calculation, however, is meaningless. They mistakenly use
the figures for nominal GNP to represent the size of the economy,
figures that include the effects of inflation. Nominal GNP is equal
to the price level multiplied by real GNP, the amount of goods and
services that the country produces.As a result, nominal GNP can
increase merely because of inflation. Real GNP, in contrast, can
increase only when people work more, when firms invest more, or
when productivity increases. To determine if deficits are large
in relation to the size of the economy, it is necessary to use figures
for real GNP, figures that are not adulterated by inflation.

To see why it is meaningless to calculate federal debt as
a percentage of nominal GNP, consider what happens to this percentage
under an extreme assumption: that federal debt is the sole cause
of inflation. Under this assumption, suppose that federal debt
doubles during a certain period. What happens? The price level
doubles, which is to say the rate of inflation is 100 percent.
Nominal GNP likewise doubles, supposing that output remains
the same. But despite the rapid rate of inflation, federal debt
as a percentage of nominal GNP remains exactly the same as it
was, because both figures have simply doubled. The conclusion
is inescapable: Computing federal debt as a percentage of nominal
GNP is irrelevant for determining if debt growth causes inflation.
Even if debt growth were the sole cause of inflation, this computation
could not detect it.

To compare the size of the federal debt with the size of the
economy, the economy must be represented by the quantity of
real goods that the country produces. That is, real GNP, not
nominal GNP, is the relevant measure. When the amount of federal
debt is computed as a percentage of real GNP, the claim that
increases in federal debt are closely related to inflation cannot
be easily dismissed. (See Figure 2.) From 1959 to 1969, when
inflation was low, federal government debt as a percentage of
real GNP dropped slightly. From 1969 to 1978, when inflation
was high, it nearly doubled. Even when the scale of the economy
is considered, federal debt in the inflationary decade of the
1970s has grown more rapidly than in the relatively stable 1960s.

A tax cut that reduces revenues and increases deficits, therefore,
would merely substitute the inflation tax for explicit taxes.
It would not lower the amount taxpayers relinquish to the government.

The Costs of Inflation

Why, then, has the inflation tax been used so extensively? Congress
has apparently found it easier to legislate inflation than to
increase direct taxes, because many prominent economic models
erroneously imply that inflation isn't a serious hardship. In
these models, inflation has no economic costs—it does not
reduce output. Although most economists would agree that a highly
unpredictable rate of inflation makes planning more hit-and-miss
and increases the odds of making damaging economic decisions,
their models typically do not reveal these costs. In most models,
in fact, inflation is neutral, its costs negligible.

Keynesian models, for instance, imply not only that inflation
is costless, but that it has tremendous benefits. In these models
it is possible to raise output and employment indefinitely simply
by raising inflation. On average, in Keynesian models, inflation
makes the economy perform better. Monetarist models also imply
that the cost of inflation is low, although not as low as in Keynesian
models. In monetarist models the cost of inflation is zero, because
higher prices have no effect on real output. When inflation is
fully anticipated, wages, incomes, prices, and interest rates
all go up in unison and no one is really harmed. When inflation
is not anticipated, it causes some redistribution of income from
creditors to debtors, but one person's losses are balanced by
another's gains, so the economy as a whole is unaffected. In these
models, that is, inflation produces no deadweight loss—no
wasted resources of any sort.

But inflation is never neutral. It is a real tax that lowers
real output, even when it is fully anticipated.

The inflation tax lowers output—or, in other words, lowers
real income—because it produces a high deadweight loss.
Inflation gives people incentives to use their time and physical
goods in less productive ways. It encourages them to use their
resources in ways they wouldn't dream of if more explicit taxes
replaced the inflation tax.

It does this by making money less desirable as a means of exchange
and a store of value. Inflation can be defined as the rate of
increase in the price level or as the rate of decline in the value
of each unit of fiat paper. By either definition, when inflation
accelerates, the real rate of return on currency and outstanding
federal bonds falls. This begins a chain reaction. When the rate
of return on money falls, more real resources—physical goods
that would otherwise be used to produce something—are devoted
to cash management techniques. A lot of labor, computers, and
office space, for instance, are now being used to allow individuals
to substitute interest-bearing assets for idle cash.

When resources are diverted to nonproductive uses—when
a steel company finds it necessary to hire someone to minimize
its cash holdings instead of someone who produces steel—the
rates of return on capital should fall. Sure enough, they have
fallen as deficits have increased and inflation has accelerated
in the 1970s. Although individuals find it in their own best interests
to hold less money when inflation rises, substituting productive
capital for money is wasteful for the economy as a whole.

A lower return on capital is not the only problem related to
deficit financing and the subsequent inflation tax, as Figure
3 shows. As the return on capital has fallen, business has become
more reluctant to add to its capital stock. Because of this, workers
have been forced to work with less capital than they otherwise
would—they use fewer or older machines, for example. As
a result, they have not produced as much as they could have. Thus,
productivity and total output have both grown more slowly than
they would have. The data, in short, are consistent with the view
that the greater inflation taxes of the 1970s have caused a decline
in the real rate of return on capital, a decline in the rate of
capital accumulation, a decline in productivity growth, and a
decline in overall economic growth.

Some of this slower growth might be blamed on greater uncertainty
about inflation or government policy. However, even if this
uncertainty could be eliminated, inflation would still have
large costs. The inflation tax has been allowed to become very
high and do a lot of damage to the economy. *

*Some have argued that the deterioration in economic performance
in the 1970s is due to higher energy prices. But even when the
rise in the relative price of energy was modest, as it was from
1970 to 1978, economic performance was hardly exemplary. Over
this period the energy subindex of the consumer price index rose
at an average annual rate of 8.7 percent—only modestly faster
than the total CPI, which rose at an average annual rate of 6.6
percent. When the period from 1970 to 1978 is compared to the
1960s, the economic performance of the 1970s still looks poor.
It is doubtful, then, that energy prices can explain the deterioration
of economic performance in the 1970s.

Popular Tax-Cut Proposals

Most of the frequently proposed tax cuts amount to using explicit
taxes less and the inflation tax more, since they would almost
certainly lower tax revenues and increase deficits. They are
thus misleading and potentially harmful.

One type of tax cut that has been proposed with slight variations
over the last several years is the antirecession tax cut. It
is designed to lower tax rates in general so that tax revenues
fall. Its advocates admit that it would increase inflation,
but they claim that the cost of the extra inflation would be
trivial compared to the benefits. As prices rise, their argument
goes, workers on inflexible contracts could not receive compensating
raises so that their real, or inflation-adjusted, wages would
fall. Because of the lower real wages, employers would demand
more labor and output would increase. The supposed result of
the antirecession tax cut, then, is a slight increase in inflation
and substantially more employment and output.

This kind of reasoning got us into the economic swamp we're
in now. It is wrong for at least three reasons.

First, it is wrong because it assumes that people can be repeatedly
fooled by a policy of cutting taxes whenever an economic downturn
appears. It assumes not that people make random errors in guessing
about the economic future, but that they make systematic errors
that government policy can exploit to make them better off in
spite of themselves. This assumption is not well founded. The
best current theories suggest that people cannot be so easily
fooled and that government is not so omnipotent. When employers
and employees are concerned about real wages and both foresee
an increase in prices, then nominal wages rise. This offsets
the price increases and keeps employment and output from rising.

The reasoning behind the antirecession tax cut is wrong, secondly,
because it relies on only half of what the advocates' economic
models predict. Advocates of this kind of tax cut emphasize
that it could produce some temporary gain in employment or output,
but they ignore another prediction from the same models: the
prediction that this gain will soon be completely wiped out.
After a few years, we will be left only with higher inflation.
The advocates say "buy now" and forget to mention "pay later."

The reasoning of the advocates of the antirecession tax cut
is wrong, thirdly, because it ignores the uncertainty of their
models. when the advocates announce that their models predict,
say, -1 percent real growth for the year ahead, they fail to
note that the models really predict a range of economic outcomes.
With reasonable confidence they can say only that economic growth
will turn out to be between something like -5 percent and +3
percent, a range so wide as to be of little value for determining
the impact of a tax cut. So when economists forecast, for example,
that a $25 billion tax cut will add 1 percentage point to real
growth, the implied certainty of their forecast is ludicrous.
If policymakers were made aware of the uncertainty surrounding
economic forecasts, they would have to be much more cautious
about recommending an antirecession tax cut.

The most basic problem with the antirecession tax cut, though,
is the familiar one. It would create higher inflation, and inflation
is not free. Such a tax cut would be costly.

Another common proposal for a tax cut is the incentive tax cut.
It is designed to lower a specific tax rate, such as the payroll
tax rate or the business tax rate, in order to provide incentives
for individuals to produce more or invest more. Incentive tax
cuts, however, would quickly cause larger deficits and more inflation.
This would probably take away more incentives than it would provide.
Lowering a specific tax rate would lower the deadweight loss caused
by that specific tax—the amount of legislative time, lawyers'
fees, office space, and other resources consumed by that tax.
But it would simultaneously increase the deadweight loss caused
by inflation—the erosion of people's savings, the weakening
of bond markets, the obstacles to establishing long-term contracts,
and so on. The incentives provided by the right hand would be
taken away by the left, and with a vengeance.

Some economists and editorialists contend that tax rates can
be cut without losing tax revenues. It is much more likely,
however, that a cut in tax rates would lower revenues. (See
below: "The Uncertainties of the Laffer Effect.")

Neither of the two main versions of the incentive tax cut
is likely to succeed. One version, the payroll tax cut, is a
plan to reduce the payroll taxes that employers pay on every
worker. This, it is supposed, would lower the cost of labor.
Businesses would respond by hiring more workers, the additional
workers would generate more output and, as this additional output
reached the market, prices would tend to be lower.

If the payroll tax cut really worked this way, then we should
eliminate all payroll taxes. This, supposedly, would increase
employment even further. Perhaps we should even offer businesses
a large tax rebate for every employee hired. If the rebate were
large enough, this would supposedly stop inflation altogether.
The payroll tax cut, of course, would not work like this, because
government can't just give away money it does not have. If government
really wants to lower payroll taxes, it has to reduce its expenditures
or raise other taxes to make up for lost revenues. But then
the tax cut might create jobs in one sector by eliminating them
in another.

Of course, government could finance the payroll tax cut with
more fiat paper, more unbacked debt. And unless it should undergo
the most spectacular conversion since Paul went to Damascus,
that is what it would do. If the government printed more fiat
paper,we would, of course, have more inflation. Labor would
doubtlessly recognize this, as it has in the past, and would
immediately demand higher wages. Then, the payroll tax cut would
only transform a tax levied on employers into an inflation tax
levied on everyone. Because of higher inflation, the promised
increase in output would fail to materialize.

Another version of the incentive tax cut, the business tax cut,
is a plan to encourage investment. The argument for this plan
is that a cut in business taxes will increase profitability and,
hence, the return on capital. Business will then be motivated
to invest more, and the increase in capital will generate more
output and lower prices. The plan, however, has the crucial weakness
of the other tax-cut proposals. If government does not raise tax
revenues through another source, the business tax cut will create
higher inflation. The cost of the higher inflation would offset
the benefit of lower taxes so that business would not be motivated
to invest in more capital or increase its output.

Proponents of both the payroll tax cut and the business tax
cut are correct in one regard: the tax structure does change incentives
to work or invest. But they overlook a basic point. The real tax
burden is the amount of resources government removes directly
or indirectly from the private sector. If government does not
lower expenditures, a cut in any particular tax will be offset
by increases in other taxes, especially the inflation tax. There
are two ladies in the magician's box—two types of taxes—not
just one. while the obvious taxes may appear to be cut, the hidden
taxes are increased.

The proposed tax cuts, however, are not just slick stagecraft.
They are not merely pleasant illusions that leave everything unchanged.
They do change things—and not necessarily for the better.
As they replace direct taxes with the less efficient inflation
tax, they cause resources to be needlessly wasted. While pretending
to saw the lady in half, the magician destroys a lot of boxes.
There is every reason to believe that people would be better off
if government used the inflation tax less, since inflation is
so wasteful and harms the economy in so many ways.

A tax cut could be worthwhile if it were an honest tax cut—that
is, if government truly took fewer resources from the private
sector. To do this in any significant way, of course, it would
have to reduce expenditures, devise a more efficient tax structure,
or both. So let there be a tax cut—but let it be the real
thing and not merely a magician's illusion.

This article was prepared by Preston J. Miller, Assistant
Vice President, with assistance Alan J. Struthers, Jr., Editor,
both of the Research Department of the Federal Reserve Bank
of Minneapolis.

The Uncertainties of the Laffer Effect

The one hope that a cut in tax rates will increase tax revenues
is the "Laffer effect," but this is a slim hope at best. It depends
on the assumption that people will work significantly more when
their after-tax wages rise or that they will invest significantly
more when their after-tax profit or rate of return rises.

The presumed relationship of tax rates and tax revenues for
a particular tax, like the payroll tax or the business tax,
is shown in the chart below. As this chart indicates, when tax
rates fall to zero, revenue falls to zero. When tax rates rise
to 100 percent, revenue also falls to zero, because people have
no incentive to work. Between these two extremes lies the tax
rate that will produce the maximum revenue for this particular
tax, rate C. No one knows what this rate is. It could be close
to the middle or close to one of the extremes. Furthermore,
no one knows the shape of the curve. It could have irregularities
that do not appear on this simple chart.

The Laffer effect depends on two conditions which are highly
uncertain and unlikely. First, for any given tax, the current
tax rate must be beyond the point of maximum revenue—that
is, the tax rate must be higher than rate C. If tax rates were
cut from E to D, for instance, revenues would rise. However, since
no one knows where the point of maximum revenue is, no one can
be sure that the Laffer effect will occur. If the tax rate were
below rate C, a cut in rates would not raise revenues. If rates
were cut from B to A, for example, tax revenues would fall.

The second crucial condition that must be met for the Laffer
effect to work is that the tax cut must not be too large. Even
If we assume that the tax rate is above rate C, the Laffer effect
won't work unless it is cut just enough to bring revenues closer
to the point of maximum revenue, but not much beyond it. Lowering
tax rates from E to D or from D to C, for example, would increase
revenues. But lowering them from D to B would make revenues
fall. Since no one knows the shape of the curve or the location
of the point of maximum revenue, it would be very difficult
to cut tax rates correctly. Perhaps just a small change in rates
would carry us all the way from E to A.

If the tax rate is now higher than the point of maximum revenue
and if the rate were cut just the right amount, the Laffer effect
would work —lower tax rates would produce higher tax revenues.
Both conditions, though, are extremely uncertain.

Worse, they seem very unlikely, judging from what little evidence
is available. For the payroll tax cut to succeed, people must
work significantly more when their real after-tax wages rise,
because only then could a cut in tax rates fail to reduce tax
revenues. If payroll taxes were assessed at a lower rate and people
worked the same amount or less, tax revenues obviously would fall.
Recent data, in fact, suggest that people do not work more when
their real after-tax wages rise. If any generalizations can be
made, people seem to work less and enjoy more leisure when their
real wages rise. In recent years, at least, when real wages have
gone up, people have worked less.

Similarly, for the business tax cut to raise tax revenues,
firms must invest significantly more when their real after-tax
return rises and output must increase significantly in response
to the added investment. Output must increase enough so that
the initial decrease in taxes is offset. For example, if a tax
on business output is lowered from 50 to 45 percent, then output
would have to increase more than 10 percent to make up for lost
tax revenues. But even the proponents of the business tax cut
concede that an increase in tax revenues is highly unlikely.
They admit that tax revenues would probably drop.

Since there is a good chance that a cut in tax rates would ultimately
lower tax revenues, experimenting with such a cut would be to risk
making our high inflation rates even higher and our large budget
deficits even larger. The uncertainties of the Laffer effect seem
far too great to justify such a risk.

1979 Operating Highlights

During 1979, operating performance at the Federal Reserve Bank of
Minneapolis reflected a continuation of five-year trends in expense
control, unit cost and productivity improvement, and growth in output.
Also, a great deal of planning and preparation took place for significant
technological changes in the Bank's operations. Ninth District 1979
total operating expenses of $29.7 million represented an increase
of only 5.6 percent over 1978 levels in spite of a 9.6 percent increase
in measured output.

As the accompanying charts illustrate, five-year expense,
productivity, and unit cost trends have compared quite favorably
with standard economic indicators for both the Federal Reserve
Bank of Minneapolis and the Federal Reserve System as a whole.
Over the five-year period of 1974 through 1979, total operating
expenses have increased at an average annual rate of 6.8 percent
for the Federal Reserve System and 4.7 percent for the Federal
Reserve Bank of Minneapolis. Over the same five-year period,
measurable outputs have increased at an annual rate of approximately
7.0 percent for both the System and the Minneapolis Bank.

Unit cost performance over this period has been very strong
as 1979 unit costs are 3.2 percent below 1974 levels for the
System and 18.2 percent below 1974 levels for the Minneapolis
Bank. These compare to a 44.1 percent increase in the GNP price
deflator, which is a measure of general price level changes.

Increases in labor productivity have been a primary contributor
to the unit cost performance. Productivity has increased at
an average annual rate of 9.6 percent for the System since 1974
and 7.8 percent per year for the Minneapolis Bank. These increases
compare to an annual average increase in productivity for the
nonfarm business sector of 1.25 percent over the last five years.

In addition to the continued strong performance results, 1979
was also a year of preparation for operations in the new decade.
The Federal Reserve Bank of Minneapolis planned for major technological
changes in its operations as well as contributed to System efforts
on membership, access, and pricing issues. In the operations
area, Check Department is in the process of implementing and
testing a new generation of faster and larger capacity reader/sorters;
these are expected to be fully operational by the third quarter
of 1980. This new equipment will increase peak processing capacity
by 25 to 30 percent and substantially reduce reject and jam
rates. Delivery delays on the new sorters resulted in a shortage
of processing capacity during the fourth quarter of 1979 and
necessitated an increase in staff levels to accommodate a larger
than expected growth in check volume. This contributed to the
first annual increase in staff size for the Bank as a whole
since 1975.

Planning also took place in 1979 on the installation of new
high speed currency processing equipment in the Money Department.
This equipment, which is scheduled to be installed during the
first half of 1980, will combine individual note fitness sorting,
counterfeit detection and online destruction of unfit notes to
improve sorting efficiency and costs.

Preparations were also under way this past year for several externally
precipitated changes in the Bank's operations, including a new System
long-range automation program, a new nationwide Federal Reserve
communication system, and planning for potential changes due to
membership, access, and pricing legislation.